Table
      of Contents










**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


Washington,
      D.C. 20549







**FORM
      10-Q**




þQUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For
      the
      Quarterly Period Ended December 31, 2006





oTRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
      the
      Transition Period From _____ to _____





COMMISSION
      FILE NUMBER 0-24765





**hi/fn,
      inc.**


(Exact
      Name of Registrant as specified in its Charter)





**Delaware**
            **33-0732700**(State
                or other jurisdiction of
            (IRS
                EmployerIncorporation
                or Organization)
            Identification
                Number)





**750
      University Avenue, Los Gatos, California 95032**


(Address
      of principal executive offices and Zip Code)





Registrant’s
      telephone number, including area code: **(408)
      399-3500**





Indicate
      by check mark if the Registrant is a well-known seasoned issuer, as defined
      in Rule
      405
      of the Securities Act.





YES
o
      NO þ





Indicate
      by check mark whether the Registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the Registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.





YES
þ
      NO o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of
      the
      Exchange Act).





Large
      accelerated filer o Accelerated
      filer þ Non-accelerated filer o





Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Act).





YES
o
      NO þ


The
      number of shares outstanding of the Registrant’s Common Stock, par value $.001
      per share, was 13,971,423 at February 5, 2007.







Table
          of Contents




**TABLE
      OF CONTENTS**




PART
                  I. FINANCIAL INFORMATIONItem
                  1. Financial Statements
                  (unaudited)Condensed
                  Consolidated Balance
                  SheetsCondensed
                  Consolidated Statements of
                  OperationsCondensed
                  Consolidated Statements of Cash
                  FlowsNotes
                  to Condensed Consolidated Financial
                  StatementsItem
                  2.Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  OperationsItem
                  3.Quantitative
                  and Qualitative Disclosures About Market RisksItem
                  4. Controls and ProceduresPART
                  II. OTHER INFORMATIONItem
                  1A. Risk FactorsItem
                  6. ExhibitsSignaturesIndex
                  to ExhibitsExhibit
                  31.1Exhibit
                  31.2Exhibit
                  32.1Exhibit
                  32.2




Table
          of Contents




**HIFN,
        INC.**
 
 **INDEX
        TO FORM 10-Q**


PART
                  I. FINANCIAL
                  INFORMATIONItem
                  1.
              Financial
                Statements (unaudited)Condensed
                  Consolidated Balance Sheets
                as of December 31, 2006 and September 30, 2006
              3Condensed
                  Consolidated Statements of Operations
                for
                  the three months ended December 31, 2006 and 2005
              4Condensed
                  Consolidated Statements of Cash Flows
                for
                  the three months ended December 31, 2006 and 2005
              5Notes
                  to Condensed Consolidated Financial Statements
              6
                  -
                  14Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              15
                  - 23Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market Risks
              24Item
                  4.
              Controls
                  and Procedures
              24PART
                  II.
              OTHER
                  INFORMATION
              25Item
                  1A.
              Risk
                  Factors
              25
                  - 35Item
                  6.
              Exhibits
              35Signatures
              36Index
                  to Exhibits


-2-
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            of Contents


**PART
      1 - FINANCIAL INFORMATION**





**Item
      1. Financial Statements**











**HIFN,
                INC.****CONDENSED
                CONSOLIDATED BALANCE SHEETS**(in
                thousands)
              (unaudited)December
                31,
              2006
            
            September
                30,
              2006**ASSETS**CURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            16,402
            
            $
            20,437Short-term
                investments
            
            
            21,249
            
            
            18,340Accounts
                receivable, net
            
            
            4,768
            
            
            4,614Inventories
            
            
            2,520
            
            
            2,028Prepaid
                expenses and other current assets
            
            
            1,455
            
            
            1,571Total
                current assets
            
            
            46,394
            
            
            46,990Property
                and equipment, net
            
            
            2,183
            
            
            2,356Intangible
                assets, net
            
            
            6,144
            
            
            6,881Other
                assets
            
            
            1,381
            
            
            1,249$
            56,102
            
            $
            57,476**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**CURRENT
                LIABILITIES:Accounts
                payable
            
            $
            2,503
            
            $
            1,672Accrued
                expenses and other current liabilities
            
            
            4,901
            
            
            5,119Total
                current liabilities
            
            
            7,404
            
            
            6,791STOCKHOLDERS’
                EQUITY:Common
                stock
            
            
            14
            
            
            14Additional
                paid-in capital
            
            
            166,814
            
            
            166,100Accumulated
                other comprehensive loss
            
            
            -
            
            
            (1
            )Accumulated
                deficit
            
            
            (113,877
            )
            
            (111,175
            )Treasury
                stock, at cost
            
            
            (4,253
            )
            
            (4,253
            )Total
                stockholders’ equity
            
            
            48,698
            
            
            50,685$
            56,102
            
            $
            57,476







See
      accompanying notes to condensed consolidated financial
      statements.


-3-
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**HIFN,
                INC.**
              **CONDENSED
                CONSOLIDATED STATEMENTS OF OPERATIONS**(in
                thousands, except per share data)
              (unaudited)Three
                Months Ended
              December
                31,2006
            
            2005Net
                revenues:Processors
            
            $
            8,565
            
            $
            9,906Software
                licenses and other
            
            
            704
            
            
            766Total
                net revenues
            
            
            9,269
            
            
            10,672Costs
                and operating expenses:Cost
                of revenues
                -
                processors
            
            
            3,122
            
            
            3,571Cost
                of revenues
                -
                software licenses and other
            
            
            82
            
            
            126Research
                and development
            
            
            4,319
            
            
            5,076Sales
                and marketing
            
            
            1,822
            
            
            1,801General
                and administrative
            
            
            2,442
            
            
            1,455Amortization
                of intangible assets
            
            
            737
            
            
            797Total
                costs and operating expenses
            
            
            12,524
            
            
            12,826Loss
                from operations
            
            
            (3,255
            )
            
            (2,154
            )Interest
                and other income,
                net
            
            
            490
            
            
            415Loss
                before income taxes
            
            
            (2,765
            )
            
            (1,739
            )Benefit
                from income taxes
            
            
            (63
            )
            
            (77
            )Netloss
            
            $
            (2,702
            )
            $
            (1,662
            )Net
                loss per share, basic and diluted
            
            $
            (0.19
            )
            $
            (0.12
            )Weighted
                average shares outstanding, basic and diluted
            
            
            13,948
            
            
            13,613







See
      accompanying notes to condensed consolidated financial statements.




-4-
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**HIFN,
                INC.****CONDENSED
                CONSOLIDATED STATEMENTS OF CASH FLOWS**(in
                thousands)
              (unaudited)Three
                Months Ended
              December
                31,2006
            
            2005Cash
                flows from operating activities:Net
                loss
            
            $
            (2,702
            )
            $
            (1,662
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            471
            
            
            399Amortization
                of intangible assets
            
            
            737
            
            
            797Stock-based
                compensation expense related
            
            
            443
            
            
            207Provision
                for (recovery of) excess and obsolete inventory
            
            
            (77
            )
            
            72Reduction
                of allowance for doubtful accounts
            
            
            (15
            )
            
            -Changes
                in assets and liabilities:Accounts
                receivable
            
            
            (139
            )
            
            (74
            )Inventories
            
            
            (415
            )
            
            458Prepaid
                expenses and other current assets
            
            
            116
            
            
            (144
            )Other
                assets
            
            
            (319
            )
            
            (79
            )Accounts
                payable
            
            
            831
            
            
            2,280Accrued
                expenses and other current liabilities
            
            
            (218
            )
            
            (1,921
            )Net
                cash provided by (used in) operating activities
            
            
            (1,287
            )
            
            333Cash
                flows from investing activities:Sale
                and maturities of short-term investments
            
            
            8,266
            
            
            8,899Purchases
                of short-term investments
            
            
            (11,174
            )
            
            (843
            )Purchases
                of property and equipment
            
            
            (111
            )
            
            (396
            )Net
                cash provided by (used in) investment activities
            
            
            (3,019
            )
            
            7,660Cash
                flows from financing activities:Proceeds
                from issuance of common stock for stock option exercises and employee
                stock purchase plan, net
            
            
            271
            
            
            589Installment
                payments on acquired software licenses
            
            
            -
            
            
            (154
            )Net
                cash provided by financing activities
            
            
            271
            
            
            435Net
                increase (decrease) in cash and cash equivalents
            
            
            (4,035
            )
            
            8,428Cash
                and cash equivalents at beginning of period
            
            
            20,437
            
            
            23,179Cash
                and cash equivalents at end of period
            
            $
            16,402
            
            $
            31,607







See
      accompanying notes to condensed consolidated financial
      statements.


-5-
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**HIFN,
      INC.**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**(unaudited)**








**Note
      1 - Basis of Presentation**





hi/fn,
      inc., together with its subsidiaries, Hifn Limited, Hifn Netherlands B.V. and
      Hifn International and its subsidiary, Saian (Hangzhou) Microsystems, Co.,
      Ltd.,
      together with Hangzhou Ansai Information Technology Co., Ltd., a contractually
      controlled company of Hifn International, (collectively
      referred to as the “Company,” “Hifn,” “we,” “us” or “our”) is a network- and
      storage-security market leader, as recognized by independent industry analyst
      firms, including The Linley Group, that supplies major network equipment
      manufacturers (“OEMs”) with patented technology to protect information at risk,
      whether it is in transit data or data at rest. Hifn designs, develops and
      markets both hardware and software solutions to a targeted customer base of
      networking-, security- and storage-OEMs. Our solutions are attractive to
      customers because they feature high-performance, including some of the fastest
      compression processing speeds available in the market, multi-protocol
      capabilities, development tools and board level products that help reduce their
      time-to-market. Our processor solutions perform the computation-intensive tasks
      of compression, encryption and authentication, providing our customers with
      high-performance, interoperable implementations of a wide variety of
      industry-standard networking and storage protocols. Our network- and
      security-processors, compression, flow classification and content search
      solutions are used in networking, security and storage equipment such as
      routers, remote access concentrators, Virtual Private Networks (“VPN”), Virtual
      Tape Libraries (“VTL”), switches, broadband access equipment, network interface
      cards, firewalls and back-up storage devices.





The
      accompanying condensed consolidated financial statements have been prepared
      pursuant to the rules and regulations of the Securities and Exchange Commission
      regarding interim financial reporting. Accordingly, they do not include all
      of
      the information and footnotes required by generally accepted accounting
      principles for complete financial statements and should be read in conjunction
      with the Financial Statements and notes thereto included in the Company’s Annual
      Report on Form 10-K for the year ended September 30, 2006. In the opinion of
      management, the accompanying condensed consolidated financial statements contain
      all adjustments, consisting only of normal recurring adjustments, which the
      Company believes is necessary for a fair statement of the Company’s financial
      position as of December 31, 2006 and its results of operations for the three
      months ended December 31, 2006 and 2005, respectively. These condensed
      consolidated financial statements are not necessarily indicative of the results
      to be expected for the entire year.





The
      Company has an accumulated deficit of $113.9 million as of December 31, 2006
      and
      has incurred a net loss of $2.7 million during the three months ended December
      31, 2006. The Company believes that its existing cash, cash
      equivalents and short-term investments will
      fund any anticipated operating losses and purchases of capital equipment and
      will provide adequate working capital for the next twelve months. The Company’s
      liquidity is affected by many factors including, among others, the extent to
      which the Company pursues additional capital expenditures, the level of the
      Company’s product development efforts, and other factors related to the
      uncertainties of the industry and global economies. Accordingly, there can
      be no
      assurance that events in the future will not require the Company to seek
      additional capital sooner or, if so required, that such capital will be
      available on terms acceptable to the Company.





**Reclassifications**





Certain
      reclassifications have been made to the prior year consolidated financial
      statements to conform to the current year’s presentation. Such reclassifications
      had no effect on previously reported results of operations or retained
      earnings.





-6-
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Restructuring Charges




On
      June 28,
      2006, the Company implemented a restructuring plan to be more focused on the
      strategy in the networking and storage markets and to take advantage of its
      expanding development capacity in China. The actions were aimed to reduce the
      Company’s cost structure, including a reduction in its North America workforce
      by 43 employees, which represented about 21% of its overall workforce at the
      time, the impact of the termination of certain engineering projects and the
      closure of the facility in Carlsbad, California.





*Involuntary
      Termination Cost*





**Expense**
              **Accrued**
              **June
                30, 2006**
            
            **Adjustments**
            
            **Paid
                as of December 31, 2006**
            
            **Balance
                December 31, 2006**(in
                thousands)Cost
                of revenues
            
            $
            64
            
            $
            (6
            )
            $
            58
            
            $
            -Research
                and development
            
            
            471
            
            
            (17
            )
            
            454
            
            
            -Sales
                and marketing
            
            
            59
            
            
            -
            
            
            59
            
            
            -General
                and administrative
            
            
            24
            
            
            -
            
            
            24
            
            
            -Total
            
            $
            618
            
            $
            (23
            )
            $
            595
            
            $
            -





*Impairment
      Of
      Long-lived Assets*





The
      restructure resulted in a $292,000 impairment of certain software assets related
      to projects that were terminated.





*Non-recurring
      Engineering Expense Recovery*





The
      cancellation of projects resulted in the reversal of previously accrued
      non-recurring engineering costs of $516,000. This reversal is reflected in
      the
      research and development line item on the condensed consolidated statement of operations.





*Termination
      Of Operating Lease*





As
      part
      of the restructure, the Company closed its facility in Carlsbad, California
      and
      ceased use of the facility as of September 30, 2006. A liability related to
      the
      Carlsbad facility of $550,000 was accrued during the last quarter of fiscal
      year
      2006, reflecting the fair value of the future lease obligations, net of sublease
      income. The non-cancelable lease agreement for this facility terminates in
      June
      2010. At December 31, 2006, the remaining lease obligation is estimated to
      be
      $1.4 million, which will be paid monthly for the remainder of the lease contract
      period. Additional costs of approximately $74,000 were incurred in the fourth
      quarter of fiscal 2006 for the relocation of operations and equipment from
      the
      closing facility. At December 31, 2006 $515,000 of the remaining lease cost
      was
      included in accrued expenses and other current liabilities in the accompanying
      condensed consolidated balance sheet.





*Net
      Restructuring Cost*





Including
      the fair value of the lease obligation and relocation costs, the net expense
      for
      the restructure as of December 31, 2006 amounted to $995,000. All remaining
      expenses, with the exception of the lease, were paid during the first quarter
      of
      fiscal year 2007. These payments were funded by available cash on
      hand.




-7-
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**Note
      2 - Balance Sheet Components**


**December
                  31,**
                **2006**
              
              **September
                  30, 2006**(in
                  thousands)Property and equipment:Computer equipment
              
              $
              8,025
              
              $
              7,932Furniture and fixtures
              
              
              1,068
              
              
              1,068Leasehold improvements
              
              
              795
              
              
              778Office equipment
              
              
              911
              
              
              91110,799
              
              
              10,689Less: accumulated depreciation
              
              
              (8,616
              )
              
              (8,333
              )$
              2,183
              
              $
              2,356





Intangible assets:Developed and core technology
            $
            14,196
            
            $
            14,196Workforce
            
            159
            
            
            15914,355
            
            
            14,355Less: accumulated amortization
            
            (9,240
            )
            
            (8,503
            )5,115
            
            
            5,852Goodwill
            
            1,029
            
            
            1,029$
            6,144
            
            $
            6,881The estimated future amortization expense related to intangible assets
                as
                of December 31, 2006 is as follows:Fiscal year ending September 30,2007 (9 months ended)
            
            $
            2,1732008
            
            
            2,3542009
            
            
            588Total estimated amortization
            
            $
            5,115Other assets:Design tools and other licensed intellectual property
            $
            1,052
            
            $
            916Refundable deposits
            
            329
            
            
            333$
            1,381
            
            $
            1,249Accrued expenses and other current liabilities:Accrued vacant facility lease cost
            $
            1,329
            
            $
            1,560Accrued non-recurring engineering costs
            
            231
            
            
            510Compensation and employee benefits
            
            1,545
            
            
            1,964Deferred income and revenue
            
            1,329
            
            
            641Income taxes payable
            
            -
            
            
            30Other
            
            467
            
            
            414$
            4,901
            
            $
            5,119





-8-
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**Note
        3 - Net Loss Per Share**


Basic
      earnings per share is computed using the weighted average number of common
      shares outstanding for the period, without consideration for the dilutive impact
      of potential common shares that were outstanding during the period. Diluted
      earnings per share is computed using the weighted average number of common
      and
      common equivalent shares outstanding for the period. Common equivalent shares
      consist of incremental common shares issuable upon the exercise of stock
      options, using the treasury method, and are excluded from the calculation of
      diluted net loss per share if anti-dilutive.





Outstanding
      options to purchase shares of common stock and their weighted shares equivalents
      excluded from the computation of diluted earnings because of their anti-dilutive
      impact were as follows:





**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**Outstanding options to purchase common stock
            
            
            4,282,213
            
            
            4,033,016





**Note
      4 - Comprehensive Income (Loss)**




Other
      comprehensive income (loss) is defined as the change in equity of a business
      enterprise during a period from transactions and other events and circumstances
      from non-owner sources. Comprehensive income (loss) includes unrealized gains
      and losses on the Company’s available-for-sale investments. The components of
      comprehensive loss are as follows:





**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**(in
                thousands)Net loss
            
            $
            (2,702
            )
            $
            (1,662
            )Unrealized gain on financial instruments
            
            
            1
            
            
            30Comprehensive loss
            
            $
            (2,701
            )
            $
            (1,632
            )





**Note
      5 - Employee Stock Benefit Plans**





**Employee
      Stock Option Plan**





As
      of
      December 31, 2006 the Company had two employee stock option plans: the 1996
      Equity Incentive Plan (the “1996 Plan”) and the 2001 Nonstatutory Stock Option
      Plan (the “2001 Plan”). Within the quarter ended December 31, 2005, the Company
      also had a third stock option plan, the Apptitude Plan, which was assumed in
      connection with the acquisition of Apptitude, Inc. in August 2000. The Apptitude
      Plan expired on October 25, 2005. Options granted under the Apptitude Plan
      remain outstanding until exercised or cancelled.





The
      1996
      Plan had 5,449,900 shares of the Company’s Common Stock reserved for issuance
      pursuant to nonqualified and incentive stock options and restricted stock
      awards. The 1996 Plan is administered by the Board of Directors of the Company
      or its designees and provides generally that nonqualified stock options and
      restricted stock may be awarded at a price not less than 85% of the fair market
      value of the stock at the date of the award. Incentive stock options must be
      awarded at a price not less than 100% of the fair market value of the stock
      at
      the date of the award, or 110% of fair market value for awards to more than
      10%
      stockholders. Options granted under the 1996 Plan may have a term of up to
      10
      years. Options typically vest at a rate of 25% of the total grant per year
      over
      a four-year period. However, the Company may, at its discretion, implement
      a
      different vesting schedule with respect to any new stock option grant. As a
      result of early exercise features as provided for by the 1996 Plan, options
      granted are immediately exercisable subject to the Company’s repurchase rights
      which expire as options vest.




-9-
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The
      2001
      Plan had 2,000,000 shares of the Company’s Common Stock reserved for issuance
      pursuant to nonqualified stock options. The 2001 Plan is administered by the
      Company’s Board of Directors or its designees and provides generally that
      nonqualified stock options granted under the 2001 Plan may have a maximum life
      of 10 years. The terms and conditions of each stock option grant under the
      2001
      Plan are determined by a committee of the Board of Directors and are set forth
      in agreements between the recipient and the Company. Options granted under
      the
      2001 Plan generally vest over a period of four years.





The
      following table summarizes the activities and related information under the
      1996
      Plan, the Apptitude Plan and the 2001 Plan:





**Options
                Available**
              **for
                Grant**
            
            **Outstanding
                Options / Quantity**
            
            **Weighted
                Average Exercise Price (per share)**
            
            **Weighted
                Average Contractual Term**
            
            **Aggregate
                Intrinsic Value (in thousands)**Balance
                at September 30, 2006
            
            
            1,920,859
            
            
            3,539,998
            
            
            10.09Options
                granted
            
            
            (904,550
            )
            
            904,550
            
            
            5.01Options
                exercised
            
            
            -
            
            
            -
            
            
            -
            
            
            
            
            
            -Options
                cancelled
            
            
            162,335
            
            
            (162,335
            )
            
            12.09Balance
                at December 31, 2006
            
            
            1,178,644
            
            
            4,282,213
            
            
            8.94Fully
                vested and expected to vest at December 31, 2006
            
            
            
            
            
            4,145,922
            
            
            9.05
            
            
            5.33
            
            $
            949Fully
                vested and exercisable at December 31, 2006
            
            
            
            
            
            3,015,569
            
            
            10.37
            
            
            5.19
            
            $
            695








Options
      vested and exercisable as of December 31, 2006 include 172,400 shares, with
      a
      weighted average exercise price of $10.88, related to options held by the
      Company’s executive officers for which vesting was accelerated as of August 2005
      and for which a holding period relating to the timing of the sale of exercised
      options, if any, was imposed. The aggregate intrinsic value of options
      outstanding and exercisable as of December 31, 2006 represents the total
      intrinsic value, based on the Company’s closing stock price of $5.34 as of
      December 29, 2006 (the last business day for the first fiscal quarter of 2007),
      which would have been received by the option holders had the options been
      exercised as of such date.





**Employee
      Stock Purchase Plan**





The
      Company has an employee stock purchase plan (the “ESPP”) through which qualified
      employees of the Company may participate in stock ownership of the Company.
      The
      price of shares purchased under the ESPP is the lesser of 85% of the fair market
      value of the shares on the first day of each semi-annual offering period, or
      85%
      of the fair market value of the shares on the last day of the semi-annual
      offering period. During the three months ended December 31, 2006, 62,234 shares
      were issued pursuant to the ESPP, at a weighted average price of $4.36 per
      share. As of December 31, 2006, there were 518,210 shares available for future
      purchases under the ESPP. During the quarter ended December 31, 2006, $40,000
      was charged to compensation expense relating to the ESPP.





**Stock-Based
      Compensation under SFAS 123(R)**





The
      total
      stock-based compensation expense recognized was allocated as follows (in
      thousands):


-10-
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**Three
                  Months Ended**
                **December
                  31,****2006**
              
              **2005**Cost
                  of revenues
              
              $
              6
              
              $
              2Research
                  and development
              
              
              169
              
              
              113Sales
                  and marketing
              
              
              58
              
              
              34General
                  and administrative
              
              
              210
              
              
              58Total
                  stock-based compensation expense
              
              $
              443
              
              $
              207





As
      of
      December 31, 2006, there was approximately $3.6 million of total stock-based
      compensation expense, after estimated forfeitures, related to unvested employee
      stock options, which is expected to be recognized over an estimated weighted
      average amortization period of 3.15 years. The Company did not capitalize any
      stock-based compensation expense. The tax benefit, and the resulting effect
      on
      cash flows from operations and financial activities, related to stock-based
      compensation expense was not recognized as the Company currently provides a
      full
      valuation allowance for its deferred tax assets. The effect of adoption of
      SFAS
      123(R) for the three months ended December 31, 2006 was an increase in net
      loss
      of $443,000 and an increase in net loss per share of $0.03.





The
      method of valuation for share-based awards granted beginning in fiscal 2006
      is
      the Black-Scholes model. The expected term of the awards represents the
      weighted-average period the stock options are expected to remain outstanding
      which assumes that the employees’ exercise behavior is a function of the
      option’s remaining contractual life and the extent to which the option is
      in-the-money (i.e., the average stock price during the period is above the
      strike price of the stock option). The Company’s expected volatility assumption
      uses the historical volatility of the Company’s stock, as applicable for the
      expected term. Since the Company does not pay dividends, the expected dividend
      yield is zero. The risk-free interest rate assumption is based upon observed
      interest rates appropriate for the term of the Company’s employee stock options.
      The post-vesting forfeiture rate is based on the Company’s historical option
      cancellation and employee exercise information.





The
      fair
      value of employee stock options granted and employee stock purchased was
      estimated based on the following assumptions:





**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005****Stock**
              **Options**
            
            **Purchase**
              **Plan**
            
            **Stock**
              **Options**
            
            **Purchase**
              **Plan**Weighted-average
                estimated fair value
            
            
            $2.88
            
            
            $1.26
            
            
            $3.37
            
            
            $1.45Estimated
                life
            
            
            5.88
                years
            
            
            0.49
                years
            
            
            5.46
                years
            
            
            0.50
                yearsRisk-free
                interest rate
            
            
            4.62%
            
            
            4.96%
            
            
            4.24%
            
            
            3.72%Expected
                stock price volatility
            
            
            57.1%
            
            
            33.9%
            
            
            67.0%
            
            
            31.8%Dividend
                yield
            
            
            0.00%
            
            
            0.00%
            
            
            0.00%
            
            
            0.00%





**Note
      6 - Segment and Geographic Information**





The
      Company operates in one industry segment comprising the design, development
      and
      marketing of high-performance, multi-protocol packet processors - semiconductor
      devices and software. Sales by major geographic area are based on the geographic
      location of the distributor, manufacturing subcontractor or OEM who purchased
      our products, which geographic location may be different from the geographic
      locations of our end customers.


-11-
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**Three
                Months Ended December 31,****2006**
            
            **2005**(in
                thousands)North
                America:United States
            
            $
            3,555
            
            $
            4,381Other
            
            
            191
            
            
            271Total North America
            
            
            3,746
            
            
            4,652Asia:Hong Kong
            
            
            4,045
            
            
            4,583Malaysia
            
            
            687
            
            
            173Singapore
            
            
            134
            
            
            440Japan
            
            
            277
            
            
            349Thailand
            
            
            29
            
            
            98Taiwan
            
            
            -
            
            
            53Other
            
            
            -
            
            
            2Total Asia
            
            
            5,172
            
            
            5,698Europe
                and other
            
            
            351
            
            
            322Total
            
            $
            9,269
            
            $
            10,672





**Major
      Customers**





The
      Company’s major customers are generally original equipment manufacturers with
      manufacturing subcontractors who purchase products directly from us. Our
      principal end customers and their respective contribution to net revenues for
      the last three years were as follows:




**Three
                  Months Ended December 31,****2006**
              
              **2005**Cisco
                  Systems, Inc.
              
              
              53%
              
              
              56%Huawei
                  Technologies, Inc.
              
              
              15%
              
              
              10%68%
              
              
              66%


No
      other
      individual customer accounted for more than 10% of revenues in the periods
      presented.




**Property
      and Equipment**





As
      of
      December 31, 2006, the Company had net property and equipment of $1.4
      million and $824,000 in the United States and China, respectively.





**Note
      7 - Income Taxes**





The
      Company has a valuation allowance for its net deferred tax asset associated
      with
      its U.S. operations.  Until such time as the Company utilizes its U.S. net
      operating loss carryforwards and unused tax credits, a provision for taxes
      on
      the Company’s U.S. operations is expected to be substantially offset by a
      reduction in the valuation allowance.  The benefit from income taxes for
      the quarter ended December 31, 2005 and 2006 relates to the reversal of
      previously accrued tax liability on the Company’s non-U.S.
      operations.





**Note
      8 - Guarantees and Product Warranties**





*Guarantees*





In
      November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”),
“Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
      Indirect Guarantees of Indebtedness of Others.”  FIN 45
      requires


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that
      a
      liability be recorded in the guarantor’s balance sheet upon issuance of a
      guarantee. In addition, FIN 45 requires disclosures about the guarantees that
      an
      entity has issued, including a reconciliation of changes in the entity’s product
      warranty liabilities. The initial recognition and initial measurement provisions
      of FIN 45 are applicable on a prospective basis to guarantees issued or modified
      after December 31, 2002. The disclosure requirements of FIN 45 are effective
      for
      financial statements of interim or annual periods ending after December 15,
      2002. Agreements that we have determined to be within the scope of FIN 45
      include hardware and software license warranties, indemnification arrangements
      with officers and directors and indemnification arrangements with customers
      with
      respect to intellectual property. To date, the Company has not incurred material
      costs in relation to any of the above guarantees and, accordingly, adoption
      of
      this standard did not have a material impact on its financial position, results
      of operations or cash flows.





As
      permitted under Delaware law, the Company has agreements that provide
      indemnification of officers and directors for certain events or occurrences
      while the officer or director is, or was, serving at the Company’s request in
      such capacity. The indemnification period is effective for the officer’s or
      director’s lifetime. The maximum potential amount of future payments that the
      Company could be required to make under these indemnification agreements is
      unlimited; however, the Company has a Director and Officer insurance policy
      that
      limits its exposure and enables the Company to recover a portion of any future
      amounts paid. All of the indemnification agreements were grandfathered under
      the
      provisions of FIN 45 as they were in effect prior to December 31, 2002. As
      a
      result of the insurance policy coverage, the Company believes the estimated
      fair
      value of the potential liability under these agreements is minimal. Accordingly,
      the Company has not recorded any liabilities for these agreements as of December
      31, 2006.




The
      Company enters into standard indemnification agreements generally with business
      partners or customers in the ordinary course of business. Pursuant to these
      agreements, the Company indemnifies, holds harmless, and agrees to reimburse
      the
      indemnified party for losses suffered or incurred in connection with patent,
      copyright or other intellectual property infringement claims by any third party
      with respect to the Company’s products. The term of these indemnification
      agreements is generally perpetual, effective after execution of the agreement.
      The maximum potential amount of future payments the Company could be required
      to
      make under these indemnification agreements is unlimited. To date, the Company
      has not incurred costs to defend lawsuits or settle claims related to these
      indemnification agreements. Accordingly, the Company has not recorded any
      liabilities for these agreements as of December 31, 2006. However, the Company
      may, in the future, record charges related to indemnification obligations and,
      depending upon the nature of any such lawsuit or claim, the estimated fair
      value
      of such indemnification obligations may be material.





*Product
      Warranties*





The
      Company warrants that its hardware products are free from defects in material
      and workmanship under normal use and service and that its hardware and software
      products will perform in all material respects in accordance with the standard
      published specifications in effect at the time of delivery of the licensed
      products to the customer. The warranty periods generally range from three months
      to one year for software and one year for hardware. Additionally, the Company
      warrants that its maintenance services will be performed consistent with
      generally accepted industry standards through completion of the agreed upon
      services. The Company’s policy is to provide for the estimated cost of product
      and service warranties based on specific warranty claims and claim history
      as a
      charge to cost of revenues. To date, the Company has not incurred significant
      expense under its product or service warranties. As a result, the Company has
      not recorded an accrual related to product or warranty services as of December
      31, 2006. The Company assesses the need for a warranty accrual every quarter.
      There is no assurance that a warranty accrual will not be necessary in the
      future.





**Note
      9 - Recent Accounting Pronouncements**





In
      July
      2006, the FASB issued FASB Interpretation 48, “Accounting for Income Tax
      Uncertainties” (“FIN 48”). FIN 48 defines the threshold for recognizing the
      benefits of tax return positions in the financial statements as
“more-likely-than-not” to be sustained by the tax authority. The recently issued
      literature also provides guidance on the recognition, measurement and
      classification of income tax uncertainties, along with any related interest
      and
      penalties. FIN 48 also includes guidance concerning accounting for income tax
      uncertainties in interim periods and


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increases
      the level of disclosures associated with any recorded income tax uncertainties.
      FIN 48 will
      be
      effective for the Company on October 1, 2007 .
      The
      differences between the amounts recognized in the statements of financial
      position prior to the adoption of FIN 48 and the amounts reported after adoption
      will be accounted for as a cumulative-effect adjustment recorded to the
      beginning balance of retained earnings .
      We are
      evaluating the impact, if any, of adopting the provisions of FIN 48 on our
      financial position and results of operations.





In
      September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
      157”), which clarifies the definition of fair value, establishes guidelines for
      measuring fair value, and expands disclosures regarding fair value
      measurements.  SFAS 157 does not require any new fair value measurements
      and eliminates inconsistencies in guidance found in various prior accounting
      pronouncements. SFAS 157 will be effective for the Company on October 1, 2008.
      The Company is currently evaluating the impact of adopting SFAS 157 on its
      financial position, cash flows, and results of operations.




-14-
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**Item
      2. Management’s Discussion and Analysis of Financial
      Condition and Results of Operations**





***Cautionary
      Statement Regarding Forward-Looking Statements***





*This
      Quarterly Report on Form 10-Q contains forward-looking statements within the
      meaning of Section 27A of the Securities Act of 1933, as amended, and Section
      21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
      Words such as “believes,” “anticipates,” “estimates,” “expects,” and words of
      similar expressions are intended to identify forward-looking statements that
      involve risks and uncertainties. Such statements are expectations based on
      information currently available and are subject to risk, uncertainties and
      changes in condition, significance, value and effect, including those discussed
      under the heading “Risk Factors” under Part II, Item 1A below and reports filed
      by Hifn with the Securities and Exchange Commission, specifically Forms 10-K,
      8-K and 10-Q. Such risks, uncertainties and changes in condition, significance,
      value and effect could cause our actual results to differ materially from those
      anticipated events. Although we believe that the assumptions underlying the
      forward-looking statements are reasonable, any of the assumptions could prove
      inaccurate, including, but not limited to, statements as to our future operating
      results and business plans. We disclaim any intention or obligation to update
      or
      revise any forward-looking statements, whether as a result of new information,
      future events or otherwise.*





**Overview**





hi/fn,
      inc., together with its subsidiaries, Hifn Limited, Hifn Netherlands B.V. and
      Hifn International and its subsidiary, Saian (Hangzhou) Microsystems, Co.,
      Ltd.,
      together with Hangzhou Ansai Information Technology Co., Ltd., a contractually
      controlled company of Hifn International, (collectively
      referred to as the “Company,” “Hifn,” “we,” “us” or “our”) is a network- and
      storage-security market leader, as recognized by independent industry analyst
      firms, including The Linley Group, that supplies most major network equipment
      manufacturers (“OEMs”) with patented technology to protect information at risk,
      whether it is in transit data or data at rest. Hifn designs, develops and
      markets both hardware and software solutions to a targeted customer base of
      networking-, security- and storage-OEMs. Our solutions are attractive to
      customers because they feature high-performance, including some of the fastest
      compression processing speeds available in the market, multi-protocol
      capabilities, development tools and board level products that help reduce their
      time-to-market. Our processor solutions perform the computation-intensive tasks
      of compression, encryption and authentication, providing our customers with
      high-performance, interoperable implementations of a wide variety of
      industry-standard networking and storage protocols. Our network- and
      security-processors, compression, flow classification and content search
      solutions are used in networking, security and storage equipment such as
      routers, remote access concentrators, Virtual Private Networks (“VPN”), Virtual
      Tape Libraries (“VTL”), switches, broadband access equipment, network interface
      cards, firewalls and back-up storage devices.





The
      Hifn
      encryption/compression and public key processors allow network equipment vendors
      to add security functions to their products. Our encryption/compression and
      public key processors provide industry-recognized algorithms that are used
      in
      products, such as VPNs, which enable businesses to reduce wide area networking
      costs by replacing dedicated leased-lines with lower-cost IP-based networks
      such
      as the Internet. Using VPNs, businesses can also provide customers, partners
      and
      suppliers with secure, authenticated access to the corporate network, increasing
      productivity through improved communications. Storage equipment vendors use
      our
      compression processor products and recently announced VTL *Express* boards
      to improve the performance and capacity of a wide range of disk and tape back-up
      systems. For example, Storage OEMs who design in a Hifn VTL *Express* board
      can offer their customers a storage solution that reduces the time to back-up
      their systems by 50%, saving them time and money.





Hifn’s
      flow classification technology enables network equipment vendors to add unique
      traffic differentiation and recognition capabilities to their products. Our
      flow
      classification solutions provide precise details about packets and data
      traversing a network and are used in implementing and monitoring quality of
      service (“QoS”) and class of service (“CoS”), which enables businesses to
      enhance the effectiveness of their systems. Using QoS- or CoS-enabled network
      equipment, businesses can provide differentiated services to their customers
      or
      build new revenue streams based on available services. This capability is
      becoming more important to customers and end users as corporate networks are
      being flooded with VoIP and Video traffic. These types of traffic require the
      highest level of QoS to maintain their integrity and usefulness.


-15-
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          of Contents





Additionally,
      Hifn announced in 2006 the Hifn Pattern Matching (“HPM”) technology which
      accelerates regular expression pattern matching, a key search function in
      security systems such as Anti-Virus, Anti-Spam and Intrusion
      Detection/Prevention. HPM contains
      “rule compression” technology that creates a highly compact rules database
      format. The database, along with HPM’s small code footprint, can reside in a
      microprocessor cache enabling the search function to run at the speed of the
      processor. Network edge security devices and Unified Threat Management (“UTM”)
      appliances all have the same fundamental limitation: they can only process
      packets at the speed at which they can detect signatures.





Hifn’s
      network processor technology, acquired from International Business Machines
      Corporation (“IBM”), complements our security processor business and expands our
      product offerings to include a programmable, yet deterministic, device that
      performs computation-intensive, deep packet inspection for high-touch services.
      The architecture of our network processor is unique and is an architecture
      used
      with applications that require high-touch services.





**Results
      for First Fiscal Quarter**




During
      the three months ended December 31, 2006, our net revenues of $9.3 million
      represented an increase of two percent from the $9.1 million in net revenues
      reported in the previous quarter and a decrease of 13 percent from the $10.7
      million in net revenues reported in the first quarter of fiscal 2006. The
      increase from the prior quarter was a result of an increase in orders from
      our
      primary customers, Cisco and Quantum. Fluctuation in ordering patterns from
      these two customers significantly affect our revenue levels from period to
      period. Such fluctuation was notable in the fourth quarters of fiscal 2006
      when
      net revenues from Cisco decreased 44%, as compared to the immediately preceding
      quarter.





Our
      expense levels during the three months ended December 31, 2006 were higher
      than
      those of the preceding quarter, mainly due to costs associated with the
      leadership transition.





**Restructuring
      Charges**





On
      June
      28, 2006, the Company
      implemented a restructuring plan to be more focused on the strategy in the
      networking and storage markets and to take advantage of its expanding
      development capacity in China. The actions were aimed to reduce the Company’s
      cost structure, including a reduction in its North America workforce by 43
      employees, which represented about 21% of its overall workforce at the time,
      the
      impact of the termination of certain engineering projects and the closure of
      the
      facility in Carlsbad, California.





*Involuntary
      Termination Cost*





**Expense**
              **Accrued**
              **June
                30, 2006**
            
            **Adjustments**
            
            **Paid
                as of December 31, 2006**
            
            **Balance
                December 31, 2006**(in
                thousands)Cost
                of revenues
            
            $
            64
            
            $
            (6
            )
            $
            58
            
            $
            -Research
                and development
            
            
            471
            
            
            (17
            )
            
            454
            
            
            -Sales
                and marketing
            
            
            59
            
            
            -
            
            
            59
            
            
            -General
                and administrative
            
            
            24
            
            
            -
            
            
            24
            
            
            -Total
            
            $
            618
            
            $
            (23
            )
            $
            595
            
            $
            -





*Impairment
      Of
      Long-lived Assets*





The
      restructure resulted in a $292,000 impairment of certain software assets related
      to projects that were terminated.


-16-
 Table
            of Contents




Non-recurring
      Engineering Expense Recovery




The
      cancellation of projects resulted in the reversal of previously accrued
      non-recurring engineering costs of $516,000. This reversal is reflected in
      the
      research and development line item on the accompanying condensed consolidated
      statement of operations.





*Termination
      Of Operating Lease*





As
      part
      of the restructure, the Company closed its facility in Carlsbad, California
      and
      ceased use of the facility as of September 30, 2006. A liability related to
      the
      Carlsbad facility of $550,000 was accrued during the last quarter of fiscal
      year
      2006, reflecting the fair value of the future lease obligations, net of sublease
      income. The non-cancelable lease agreement for this facility terminates in
      June
      2010. At December 31, 2006, the remaining lease obligation is estimated to
      be
      $1.4 million, which will be paid monthly for the remainder of the lease contract
      period. Additional costs of approximately $74,000 were incurred in the fourth
      quarter of fiscal 2006 for the relocation of operations and equipment from
      the
      closing facility. At December 31, 2006 $515,000 of the remaining lease cost
      was
      included in accrued expenses and other current liabilities in the accompanying
      condensed consolidated balance sheet.





*Net
      Restructuring Cost*





Including
      the fair value of the lease obligation and relocation costs, the net expense
      for
      the restructure as of December 31, 2006 amounted to $995,000. All remaining
      expenses, with the exception of the lease, were paid during the first quarter
      of
      fiscal year 2007. These payments were funded by available cash on
      hand.





**Critical
      Accounting Policies**





The
      Company’s critical accounting policies are disclosed in the Company’s Form 10-K
      for the year ended September 30, 2006 and have not changed materially as of
      December 31, 2006.





**Results
      of Operations**




The
      following table sets forth the percentage relationship of certain items to
      the
      Company’s net revenues during the periods shown:





*Net
      Revenues.*





Net
      revenues by category, as a percentage of total net revenues and the
      year-over-year change were as follows:





**Three
                Months Ended**
              **December
                31,**
            
            **Year-over-Year
                Growth****2006**
            
            **2005***(dollars
                in thousands)*
            
            **$**
            ****
            **%
                of net**
              **revenues**
            ****
            **$**
            ****
            **%
                of net revenues**Processors
            
            $
            8,565
            
            
            92%
            
            $
            9,906
            
            
            93%
            
            
            (14)%Software
                licenses and other
            
            
            704
            
            
            8%
            
            
            766
            
            
            7%
            
            
            (8)%$
            9,269
            
            
            100%
            
            $
            10,672
            
            
            100%
            
            
            (13)%





-17-
 Table
          of Contents


Net
      revenues decreased by $1.4 million for the quarter ended December 31, 2006
      as
      compared to net revenues for the quarter ended December 31, 2005. Our processor
      revenues decreased $1.3 million, mainly as a result of a decrease in sales
      of
      our network processors, due to an overall reduction in customer orders. Also
      contributing to the overall decrease in net revenues was a decrease in revenues
      from software licenses and royalties of $62,000, which is generally dependent
      upon variability in the mix, demand for and timing of customers’ purchases of
      certain of the Company’s licensed software products.




Semiconductor
      and software sales to our principal end customers and their respective
      contribution to net revenue for the respective periods were as follows:





**Three
                Months Ended December 31,****2006**
            
            **2005**Cisco
                Systems, Inc.
            
            
            53%
            
            
            56%Huawei
                Technologies, Inc.
            
            
            15%
            
            
            10%68%
            
            
            66%





*Cost
      of Revenues.*





Cost
      of
      revenues by category, as a percentage of each respective revenue category and
      the year-over-year change were as follows:




**Three
                Months Ended**
              **December
                31,**
            
            **Year-over-Year
                Growth****2006**
            
            **2005***(dollars
                in thousands)*
            
            **$**
            ****
            **%
                of revenue**
              **category**
            ****
            **$**
            ****
            **%
                of revenue category**Processors
            
            $
            3,122
            
            
            36%
            
            $
            3,571
            
            
            36%
            
            
            (13)%Software
                licenses and other
            
            
            82
            
            
            12%
            
            
            126
            
            
            16%
            
            
            (35)%$
            3,204
            
            
            35%
            
            $
            3,697
            
            
            35%
            
            
            (13)%





Cost
      of
      revenues consists primarily of cost of semiconductors which were manufactured
      to
      our specifications by third parties for resale by us. Cost of processor revenues
      as a percentage of net processor revenues remained unchanged for the three
      months ended December 31, 2006 as compared to the same period in fiscal 2005.
      Cost of software licenses and other revenues is primarily comprised of
      engineering labor related to support and maintenance of sold licenses. The
      fluctuation in software licenses and other costs as a percentage of software
      licenses and other revenues is dependent upon the mix and level of licensed
      software and royalties earned during the period.





*Operating
      Expenses*





*Research
      and Development.*


**Three
                Months Ended**
              **December
                31,**
            
            **Year-over-Year
                Growth***(dollars
                in thousands)*
            
            **2006**
            
            **2005**Research
                & development expenses
            
            $
            4,319
            
            $
            5,076
            
            
            (15)%As
                a percentage of net revenues
            
            
            47%
            
            
            48%





Research
      and development costs consist primarily of salaries, employee benefits,
      overhead, outside contractors and non-recurring engineering fees. Such research
      and development expenses decreased $757,000 for the three months ended December
      31, 2006 over the same period in the prior year. The decrease reflects a
      decrease of $925,000 in salaries and benefits expense mainly due to a reduction
      in headcount as a result of the restructure implemented in June 2006, a
      reduction in building expenses of $126,000 as a result of reduced allocation
      of
      rental and other costs mainly due to the closure of our Carlsbad facility in
      September 2006, a decrease of $133,000 in non-recurring engineering costs and
      services associated with tape-out, mask activities and qualification testing
      of


-18-
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products
      under development which is contingent upon the stage of development of projects,
      together with a decrease of $56,000 in expenses related to telephone, travel
      and
      other expenses. These decreases were offset by a $355,000 increase in software
      maintenance, $102,000 in supplies and $26,000 in depreciation, mainly due to
      increased activities in China.





*Sales
      and Marketing.*


**Three
                Months Ended**
              **December
                31,**
            
            **Year-over-Year
                Growth***(dollars
                in thousands)*
            
            **2006**
            
            **2005**Sales
                & marketing expenses
            
            $
            1,822
            
            $
            1,801
            
            
            1%As
                a percentage of net revenues
            
            
            20%
            
            
            17%





Sales
      and
      marketing expenses consist primarily of salaries, commissions and benefits
      of
      sales, marketing and support personnel as well as consulting, advertising,
      promotion and overhead expenses. Such expenses increased $21,000 for the three
      months ended December 31, 2006 over the same period in the prior year. The
      increase reflects an increase of $21,000 in building expenses as a result of
      increased allocation of rental and other costs, an increase of $52,000 in travel
      and entertainment expenses and miscellaneous expenses due to the timing of
      sales
      conferences, an increase of $48,000 in professional services for upgrading
      our
      website to serve our customers better and reduce the time spend to keep
      information up to date, together with an increase of $4,000 in other expenses.
      The increase was partially offset by a decrease in salaries and benefits of
      $35,000 due to lower sales commissions, a decrease in sales representative
      commissions of $46,000 due to a lower level of sales made through sales
      representatives, and a decrease of $23,000 in advertising and tradeshows as
      a
      result of the timing of tradeshow activities.





*General
      and Administrative.*


**Three
                Months Ended**
              **December
                31,**
            
            **Year-over-Year
                Growth***(dollars
                in thousands)*
            
            **2006**
            
            **2005**General
                & administrative expenses
            
            $
            2,442
            
            $
            1,455
            
            
            68%As
                a percentage of net revenues
            
            
            26%
            
            
            14%





General
      and administrative expenses are comprised primarily of salaries for
      administrative and corporate services personnel, legal and other professional
      fees. Such expenses increased $987,000 for the three months ended December
      31,
      2006 over the same period in the prior year. The increase reflects an increases
      in salaries and benefits of $497,000, together with $100,000 in miscellaneous
      expenses mainly due to costs associated with the transition in leadership,
      an
      increase in professional services for legal counsel and consulting of $264,000
      associated with strategic planning, an increase of $60,000 in building expenses mainly
      as
      the result of the closure of our Carlsbad facility in September 2006, and an
      increase of $75,000 in other taxes due to our China operations and the timing
      of
      local franchise tax payments. These increases were partially offset by a
      decrease of $9,000
      in other expenses.





*Amortization
      of Intangibles.*


**Three
                Months Ended**
              **December
                31,**
            
            **Year-over-Year
                Growth***(dollars
                in thousands)*
            
            **2006**
            
            **2005**Amortization
                of intangibles
            
            $
            737
            
            $
            797
            
            
            (8)%As
                a percentage of net revenues
            
            
            8%
            
            
            8%





Amortization
      of intangibles relate to acquired technology, workforce and patents.
      Amortization of intangibles decreased $60,000 for the three months ended
      December 31, 2006 over the same period in the prior year mainly as a result
      of
      the full amortization of previously capitalized intangible assets related to
      the
      NetOctave asset acquisition upon reaching their estimated useful lives as of
      the
      prior fiscal year end.


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*Interest
      and
      Other Income, net.*


**Three
                Months Ended**
              **December
                31,**
            
            **Year-over-Year
                Growth***(dollars
                in thousands)*
            
            **2006**
            
            **2005**Interest
                & other income, net
            
            $
            490
            
            $
            415
            
            
            18%As
                a percentage of net revenues
            
            
            5%
            
            
            4%





Interest
      and other income, net, increased $75,000 during the three months ended December
      31, 2006 as compared to the same period in the prior fiscal year. The increase
      was primarily a result of the
      timing in purchases of higher-average-yield instruments to take advantage of
      rising interest rates.





*Income
      Taxes.*


**Three
                Months Ended**
              **December
                31,**
            
            **Year-over-Year
                Growth***(dollars
                in thousands)*
            
            **2006**
            
            **2005**Provision
                for (benefit from) income taxes
            
            $
            (63)
            
            $
            (77)
            
            
            18%As
                a percentage of net revenues
            
            
            (1)%
            
            
            (1)%





We
      recognize income tax expense based on an asset and liability approach that
      requires recognition of deferred tax assets and liabilities related to future
      tax consequences of events recognized in both our financial statements and
      income tax returns. Prior to fiscal 2003, we recorded a full valuation allowance
      for our deferred tax assets. In fiscal 2003, we recognized a tax benefit of
      $1.8
      million related to carry back of net operating losses to prior years. We have
      not recognized tax benefits as a result of continuing losses over a longer
      period than previously expected. The benefit from income taxes for the three
      months ended December 31, 2006 reflects the reversal of previously accrued
      tax
      liability for our non-U.S. operations. We continue to consider future taxable
      income and ongoing prudent and feasible tax planning strategies in assessing
      the
      valuation allowance.





**Liquidity
      and Capital Resources**





A
      summary
      of the sources and uses of cash and cash equivalents is as follows:


**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**(in
                thousands)Net
                cash provided by (used in) operating activities
            
            $
            (1,287
            )
            $
            333Net
                cash provided by (used in) investing activities
            
            
            (3,019
            )
            
            7,660Net
                cash provided by financing activities
            
            
            271
            
            
            435Net
                decrease in cash and cash equivalents
            
            $
            (4,035
            )
            $
            8,428





*Operating
      Activities.* Net cash
      used in operating activities was $1.3 million for the three months ended
      December 31, 2006 resulting from a net loss during the period of $2.7 million,
      adjusted for non-cash items including depreciation and amortization of fixed
      assets of $471,000, amortization of intangibles related to acquired technologies
      of $737,000, stock-based compensation expenses of $443,000 and a decrease in
      the
      allowance for bad debts of $15,000 .
      These
      non-cash expenses were offset by an
      increase in accounts receivable of $139,000, reflecting a shift in the timing
      of
      shipments and payments during the first quarter of fiscal 2007, and an increase
      in inventories of $492,000, net of $77,000 in additions to the provision for
      excess and obsolete inventory, mainly
      due to the timing of receipt of inventory purchases, an increase
      in other current assets of $319,000, due to the addition of a license agreement
      in China ,
      together with a reduction in accrued liabilities of $218,000, including $279,000
      in non-recurring engineering services and $450,000 in compensation and employee
      benefits, reflecting a reduction in accrued employee stock purchase plan
      withholding as a result of the purchase in October 2006 and bonus payments,
      offset by an increase of $554,000 in deferred software revenue, due to new
      software sales during the first quarter of fiscal 2007 .
      Contributing to cash provided by operations was a reduction in prepaid expenses
      of $116,000 as
      well
      as an
      increase in accounts payable of $831,000,
      which
      was related to the timing of payments made.


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Net
      cash
      provided by operating activities of $333,000 for the three months ended
      December 31, 2005 was the result of a decrease in inventory of $530,000,
      mainly due to the timing of receipt of inventory purchases, and an increase
      in
      accounts payable of $2.3 million, which was related to the timing of payments
      made. These items were mainly offset by the net loss of $1.7 million, as
      adjusted for non-cash items including depreciation and amortization of $399,000
      related to property and equipment and licensed software, amortization of
      intangibles of $797,000 and stock-based compensation expense of $207,000, which
      was the effect of the adoption of SFAS 123(R) during the period, as well as
      a
      reduction of $1.9 million in accrued liabilities including $1.3 million in
      non-recurring engineering services and costs and $134,000 in compensation and
      employee benefits, reflecting a reduction in accrued employee stock purchase
      plan withholding as a result of the purchase in October 2005 and in accrued
      vacation as a result of utilization of accrued vacation during the holiday
      shut-down in December.




*Investing
      Activities.* Net cash
      used in investing activities was $3.0 million for the three months ended
      December 31, 2006, which primarily reflects the net purchase of short-term
      investments of $2.9 million and the purchase of property and equipment of
      $111,000, net of $41,000 in sales of property and equipment. Net cash provided
      by investing activities was $7.7 million for the three months ended
      December 31, 2005, which primarily reflects the net sale and maturities of
      short-term investments of $8.1 million offset by the purchase of property
      and equipment of $396,000.




*Financing
      Activities.* Net cash
      provided by financing activities for the three months ended December 31, 2006
      of
      $271,000 was comprised of cash proceeds from the issuance of common stock under
      our employee stock purchase plan. Net cash provided by financing activities
      for
      the three months ended December 31, 2005 of $435,000 was comprised of cash
      proceeds from the issuance of common stock for stock option exercises and
      employee stock purchase plan purchases which aggregated $589,000, offset by
      installment payments on acquired software licenses of $154,000.




The
      Company’s inventory balance increased by $492,000 to $2.5 million at December
      31, 2006 as compared to $2.0 million as of September 30, 2006. The increase
      in
      inventory is a result of the timing of inventory purchases relative to
      manufacturer lead-time, coupled with anticipated shipment schedules to fill
      customer orders for the succeeding quarter. The Company’s annualized inventory
      turns for the three months ended December 31, 2006 were 5.5 times as compared
      to
      7.2 times for the year ended September 30, 2006. The Company’s accounts
      receivable balance, which is contingent upon the timing of product shipment
      within the respective periods, increased $139,000 from September 30, 2006 to
      December 31, 2006.




The
      Company uses a number of independent suppliers to manufacture substantially
      all
      of its products. As a result, the Company relies on these suppliers to allocate
      to the Company a sufficient portion of foundry capacity to meet the Company’s
      needs and deliver sufficient quantities of the Company’s products on a timely
      basis. These arrangements allow the Company to avoid utilizing its capital
      resources for manufacturing facilities and work-in-process inventory and to
      focus substantially all of its resources on the design, development and
      marketing of its products.




The
      Company requires substantial working capital to fund its business, particularly
      to finance accounts receivable and inventory, and for investments in property
      and equipment. The Company’s need to raise capital in the future will depend on
      many factors including the rate of sales growth, market acceptance of the
      Company’s existing and new products, the amount and timing of research and
      development expenditures, the timing and size of acquisitions of businesses
      or
      technologies, the timing of the introduction of new products and the expansion
      of sales and marketing efforts. We believe that our existing cash resources
      will
      fund any anticipated operating losses, purchases of capital equipment and
      provide adequate working capital for the next twelve months. Our liquidity
      is
      affected by many factors including, among others, the extent to which we pursue
      additional capital expenditures, the level of our product development efforts,
      and other factors related to the uncertainties of the industry and global
      economies. Accordingly, there can be no assurance that events in the future
      will
      not require us to seek additional capital sooner or, if so required, that such
      capital will be available at all or on terms acceptable to us.


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*Common
      Stock Repurchase.* On April
      25, 2005, the Company’s Board of Directors authorized a stock repurchase program
      whereby the Company may repurchase shares of the Company’s common stock with an
      aggregate fair market value of up to $10 million from time to time through
      open
      market and privately negotiated transactions at prices determined by management.
      The timing and amount of repurchases under this program were dependent on market
      conditions and corporate and regulatory considerations. The purchase was funded
      from available working capital. The stock repurchase program expired on April
      25, 2006. The aggregate repurchase was a total of 692,894 shares at a cost
      of
      approximately $4.3 million.





**Contractual
      Obligations**





The
      Company occupies its facilities under several non-cancelable operating leases
      that expire at various dates through November 2011, and which contain renewal
      options. Additionally, contractual obligations were also entered into related
      to
      non-recurring engineering services and inventory purchases. Payment obligations
      for such commitments as of December 31, 2006 are as follows:





**Payments
                Due By Period****Contractual
                Obligations**
            
            **Total**
            
            **Less
                than**
              **1
                year**
            
            **1
                - 3**
              **years**
            
            **3
                - 5**
              **years**
            
            **More
                than 5 years**(in
                thousands)Operating
                lease commitments
            
            $
            4,674
            
            $
            2,123
            
            $
            2,119
            
            $
            432
            
            $
            -Inventory
                purchases
            
            
            3,152
            
            
            3,152
            
            
            -
            
            
            -
            
            
            -Non-recurring
                engineering expense
            
            
            231
            
            
            231
            
            
            -
            
            
            -
            
            
            -Totals
            
            $
            8,057
            
            $
            5,506
            
            $
            2,119
            
            $
            432
            
            $
            -  **Off-Balance
      Sheet Arrangements**





The
      Company has no off-balance sheet arrangements that have or are reasonably likely
      to have a current or future effect on the Company’s financial condition,
      revenues or expenses, results of operations, liquidity, capital expenditures
      or
      capital resources that may be material to investors.





**Guarantees
      and Product Warranties**





*Guarantees*





In
      November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”),
“Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
      Indirect Guarantees of Indebtedness of Others.”  FIN 45 requires that a
      liability be recorded in the guarantor’s balance sheet upon issuance of a
      guarantee. In addition, FIN 45 requires disclosures about the guarantees that
      an
      entity has issued, including a reconciliation of changes in the entity’s product
      warranty liabilities. The initial recognition and initial measurement provisions
      of FIN 45 are applicable on a prospective basis to guarantees issued or modified
      after December 31, 2002. The disclosure requirements of FIN 45 are effective
      for
      financial statements of interim or annual periods ending after December 15,
      2002. Agreements that we have determined to be within the scope of FIN 45
      include hardware and software license warranties, indemnification arrangements
      with officers and directors and indemnification arrangements with customers
      with
      respect to intellectual property. To date, the Company has not incurred material
      costs in relation to any of the above guarantees and, accordingly, adoption
      of
      this standard did not have a material impact on its financial position, results
      of operations or cash flows.





As
      permitted under Delaware law, the Company has agreements that provide
      indemnification of officers and directors for certain events or occurrences
      while the officer or director is, or was, serving at the Company’s request in
      such capacity. The indemnification period is effective for the officer’s or
      director’s lifetime. The maximum potential amount of future payments that the
      Company could be required to make under these indemnification agreements is
      unlimited; however, the Company has a Director and Officer insurance policy
      that
      limits its exposure and enables the Company to recover a portion of any future
      amounts paid. All of the indemnification agreements were grandfathered under
      the
      provisions of FIN 45 as they were in effect prior to December 31, 2002. As
      a
      result of the insurance policy coverage, the Company believes the estimated
      fair
      value of the potential liability under these agreements is minimal. Accordingly,
      the Company has not recorded any liabilities for these agreements as of December
      31, 2006.


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The
      Company enters into standard indemnification agreements generally with business
      partners or customers in the ordinary course of business. Pursuant to these
      agreements, the Company indemnifies, holds harmless, and agrees to reimburse
      the
      indemnified party for losses suffered or incurred in connection with patent,
      copyright or other intellectual property infringement claims by any third party
      with respect to the Company’s products. The term of these indemnification
      agreements is generally perpetual, effective after execution of the agreement.
      The maximum potential amount of future payments the Company could be required
      to
      make under these indemnification agreements is unlimited. To date, the Company
      has not incurred costs to defend lawsuits or settle claims related to these
      indemnification agreements. Accordingly, the Company has not recorded any
      liabilities for these agreements as of December 31, 2006. However, the Company
      may, in the future, record charges related to indemnification obligations and,
      depending upon the nature of any such lawsuit or claim, the estimated fair
      value
      of such indemnification obligations may be material.





*Product
      Warranties*





The
      Company warrants that its hardware products are free from defects in material
      and workmanship under normal use and service and that its hardware and software
      products will perform in all material respects in accordance with the standard
      published specifications in effect at the time of delivery of the licensed
      products to the customer. The warranty periods generally range from three months
      to one year for software and one year for hardware. Additionally, the Company
      warrants that its maintenance services will be performed consistent with
      generally accepted industry standards through completion of the agreed upon
      services. The Company’s policy is to provide for the estimated cost of product
      and service warranties based on specific warranty claims and claim history
      as a
      charge to cost of revenues. To date, the Company has not incurred significant
      expense under its product or service warranties. As a result, the Company has
      not recorded an accrual related to product or warranty services as of December
      31, 2006. The Company assesses the need for a warranty accrual every quarter.
      There is no assurance that a warranty accrual will not be necessary in the
      future.





**Recent
      Accounting Pronouncements**





In
      July
      2006, the FASB issued FASB Interpretation 48, “Accounting for Income Tax
      Uncertainties” (“FIN 48”). FIN 48 defines the threshold for recognizing the
      benefits of tax return positions in the financial statements as
“more-likely-than-not” to be sustained by the tax authority. The recently issued
      literature also provides guidance on the recognition, measurement and
      classification of income tax uncertainties, along with any related interest
      and
      penalties. FIN 48 also includes guidance concerning accounting for income tax
      uncertainties in interim periods and increases the level of disclosures
      associated with any recorded income tax uncertainties. FIN 48 will
      be
      effective for the Company on October 1, 2007 .
      The
      differences between the amounts recognized in the statements of financial
      position prior to the adoption of FIN 48 and the amounts reported after adoption
      will be accounted for as a cumulative-effect adjustment recorded to the
      beginning balance of retained earnings .
      We are
      evaluating the impact, if any, of adopting the provisions of FIN 48 on our
      financial position and results of operations.





In
      September
      2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”),
      which clarifies the definition of fair value, establishes guidelines for
      measuring fair value, and expands disclosures regarding fair value
      measurements.  SFAS 157 does not require any new fair value measurements
      and eliminates inconsistencies in guidance found in various prior accounting
      pronouncements.  SFAS 157 will be effective for the Company on October 1,
      2008. The Company is currently evaluating the impact of adopting SFAS 157 on
      its
      financial position, cash flows, and results of operations.





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**Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk**





*Interest
      Rate Risk* .
      The
      Company does not use derivative financial instruments in its investment
      portfolio. The Company’s investment portfolio is generally comprised of
      commercial paper. The Company places investments in instruments that meet high
      credit quality standards. These securities are subject to interest rate risk,
      and could decline in value if interest rates fluctuate. Due to the short
      duration and conservative nature of the Company’s investment portfolio, the
      Company does not expect any material loss with respect to its investment
      portfolio. A 10% change in interest rates at December 31, 2006 would have an
      immaterial effect on the Company’s pre-tax earnings and the fair value of its
      investments.





*Foreign
      Currency Exchange Rate Risk* .
      All of
      the Company’s sales, cost of manufacturing and marketing are transacted in U.S.
      dollars. Accordingly, the Company’s results of operations are not subject to
      foreign exchange rate fluctuations. To date, we have not incurred any
      significant gains or losses from such fluctuations.





**Item
      4. Controls and Procedures**





(a) *Evaluation of disclosure controls and procedures.*  We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed by us in reports that we file or submit
      under the Securities Exchange Act of 1934, as amended, is recorded, processed,
      summarized and reported within the time periods specified in Securities and
      Exchange Commission (“SEC”) rules and forms and that such information is
      accumulated and communicated to our management, including our Chief Executive
      Officer and Chief Financial Officer, as appropriate to allow timely decisions
      regarding required disclosure.





Based
      on
      their evaluation as of the end of the period covered by this Quarterly Report
      on
      Form 10-Q, our Chief Executive Officer and Chief Financial Officer have
      concluded that, as of the end of such period, our disclosure controls and
      procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
      Exchange Act of 1934, as amended, were effective to ensure that information
      that
      is required to be disclosed in this Quarterly Report on Form 10-Q is recorded,
      processed, summarized and reported within the time periods specified in SEC
      rules and forms and is accumulated and communicated to our Chief Executive
      Officer and Chief Financial Officer, as appropriate, to allow timely decisions
      regarding required disclosure.





(b)  *Changes
      in internal controls over financial reporting.* There
      was no change in our internal control over financial reporting that was
      identified in connection with our evaluation of disclosure controls and
      procedures that occurred during the quarter ended December 31, 2006 that has
      materially affected, or is reasonably likely to materially affect, our internal
      control over financial reporting.


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**PART
      II - OTHER INFORMATION**





**Item 1A.** ***Risk
      Factors***





In
      future
      periods, Hifn’s business, financial condition and results of operations may be
      affected by many factors including, but not limited to, the
      following:





**Restructuring
      Activities May Result In Unforeseen Negative Results To Operations And Customer
      Relations.**





On
      June 28, 2006 the Company announced a restructuring that reduced engineering
      personnel and associated operating expenses in an effort to return to
      profitability. Certain development projects were cancelled. The Company does
      not
      expect the cancellation of these projects to have an adverse effect on customer
      relations, but this cannot be assured.  With redirected engineering effort,
      particularly in the area of network processing, customers may accelerate their
      migration from existing designs to alternative solutions from our competitors.
      The restructure may not achieve the expected benefits, and future restructuring
      may be necessary.





With
      the
      closing of the Carlsbad, California facility, the order fulfillment function
      was
      transferred to our Los Gatos, California facility during the last quarter of
      fiscal 2006. This move may affect the timely shipment of products to the
      Company's customers.





The
      restructuring significantly reduced the research and development resources
      in
      the United States.  While the Company believes that the relations with the
      employees still remain good, it is possible that the Company may experience
      unanticipated turnover from the remaining staff.





**The
      Company May Have Difficulty Establishing Adequate Management, Legal, and
      Financial Controls in the People’s Republic of China.**





The
      People's
      Republic of China (“PRC”) historically has been deficient in Western style
      management and financial reporting concepts and practices, as well as in modern
      banking, computer and other control systems. In addition, the Company may have
      difficulty in hiring and retaining a sufficient number of qualified employees
      to
      work in the PRC. As a result of these factors, the Company may experience
      difficulty in establishing management, legal and financial controls, collecting
      financial data, books of account and records and instituting business practices
      that meet Western standards.





**If
      We Are Unable to Protect Our Proprietary Technology, Our Ability to Succeed
      Will
      be Harmed.**





Our
      ability to compete successfully and achieve future growth will depend, in part,
      on our ability to protect our proprietary technology. We rely on a combination
      of patent, copyright, trademark, and trade secret laws and restrictions on
      disclosure to protect our intellectual property rights. However, the steps
      we
      have taken may not prevent the misappropriation of our intellectual property,
      particularly in foreign countries, such as the PRC, where the laws may not
      protect our proprietary rights as fully as in the United States. If we are
      unable to protect our proprietary technology, our ability to succeed will be
      harmed. Moreover, we may in the future initiate claims or litigation against
      third parties for infringement of our proprietary rights. These claims could
      result in costly litigation and the diversion of the attention of our technical
      and management personnel.





**Our
      Contractual Arrangement with Hangzhou Ansai Information Technology May Not
      Be As
      Effective as Direct Ownership.**





Since a wholly
      foreign-owned enterprise is precluded by regulation or otherwise from conducting
      activities in certain industry sectors and participating in certain research
      projects in the
      PRC’s, Hifn opted to create a contractually controlled company called Hangzhou
      Ansai Information Technology Co., Ltd. (“Ansai”), to expand our business in the
      PRC. Hifn International, one of the subsidiaries of Hifn, controls Ansai by
      contractual arrangement only and does not have any equity ownership in the
      company. These contractual arrangements may not provide control
      over Ansai similar to that of direct ownership,
      making
      it more difficult for Hifn to ensure effective oversight of operations in the
      PRC.


-25-
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          of Contents





**Our
      Business Depends Upon The Development Of The Packet Processor Market.**





Our
      prospects are dependent upon the acceptance of packet processors as an
      alternative to other technology traditionally utilized by network and storage
      equipment vendors. Many of our current and potential customers have substantial
      technological capabilities and financial resources and currently develop
      internally the application specific integrated circuit components and program
      the general purpose microprocessors utilized in their products as an alternative
      to our packet processors. These customers may in the future continue to rely
      on
      these solutions or may determine to develop or acquire components, technologies
      or packet processors that are similar to, or that may be substituted for, our
      products. In order to be successful, we must anticipate market trends and the
      price, performance and functionality requirements of such network and storage
      equipment vendors and must successfully develop and manufacture products that
      meet their requirements. In addition, we must make products available to these
      large customers on a timely basis and at competitive prices. If orders from
      customers are cancelled, decreased or delayed, or if we fail to obtain
      significant orders from new customers, or if any significant customer delays
      or
      fails to pay, our business, financial condition and results of operations could
      suffer.




**Our
      Business Depends Upon The Continued Growth of the Network Equipment and Storage
      Equipment Markets And Our Penetration Of The Virtual Private Network, iSCSI,
      Network Processor and Virtual Tape Library Markets.**





Our
      success is largely dependent upon continued growth in the market for network
      security equipment, such as routers, remote access concentrators, switches,
      broadband access equipment, security gateways, firewalls and network interface
      cards. Our success also depends upon storage equipment vendors incorporating
      our
      compression security products into their systems. The virtual tape library
      products from storage system vendors incorporate our compression products and
      our goal is to become a leading supplier for compression in those markets.
      We
      also want to be a leading supplier of packet processors that implement the
      network security protocols necessary to support the deployment of virtual
      private networks. Additionally, we have entered into the network processor
      market and developed products that we anticipate fulfills the need for security
      in the iSCSI market.





These
      markets, which are either emerging or evolving, may not grow or be material.
      Alternatively, if they do emerge or continue to grow, our products may not
      successfully serve these markets. Our ability to generate significant revenue
      in
      the network and storage equipment, virtual private network, network processor,
      iSCSI and virtual tape library markets will depend upon, among other things,
      the
      following:





·
            Capital
                spending levels;





·
            Additions
                to, changes in or lack of industry
                standards;





·
            Our
                ability to demonstrate the benefits of our technology to distributors,
                original equipment manufacturers and end
                users;





·
            The
                increased use of the Internet by businesses as replacements for,
                or
                enhancements to, their private
                networks;





·
            The
                adoption of security as a necessary feature in iSCSI;
                and





·
            The
                adoption of compression as a necessary feature in virtual tape library
                products.





We
      are
      unable to determine the rate or extent to which the network equipment and
      storage markets will grow, if at all. Additionally, if we are unable to
      penetrate the virtual private network, network processor, iSCSI or virtual
      tape
      library markets, or if these markets fail to develop, our business, financial
      condition and results of operations could suffer. Any decrease in the growth
      of
      the network or storage equipment market, a decline in demand for our products
      or
      our inability to penetrate new markets could harm our business, financial
      condition and results of operations.


-26-
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**Because
      We Depend Upon A Small Number Of Customers, If Our Sales To Any Of These
      Customers Decline, Our Business, Financial Condition and Results of Operations
      May Suffer.**





The
      Company’s major customers are generally original equipment manufacturers with
      manufacturing subcontractors who purchase products directly from us. Our
      principal end customers and their respective contribution to net revenues for
      the last three years are as follows:





**Three
                Months Ended December 31,**
            
            **Year****Ended**
              **September****30,****2006**
            
            **2005**
            
            **2006**Cisco
                Systems, Inc.
            
            
            53%
            
            
            56%
            
            
            50%Huawei
                Technologies, Inc.
            
            
            15%
            
            
            10%
            
            
            13%68%
            
            
            66%
            
            
            63%





Cisco
      and
      Huawei are not under any binding obligation to order from us. If our sales
      to
      Cisco or Huawei decline, our business, financial condition and results of
      operations could suffer. During the three months ended December 31, 2006, sales
      to Cisco increased 38% while sales to Huawei decreased two percent, over
      revenues generated from each respective customer in the preceding quarter,
      significantly affecting the Company’s revenue levels and results of operations
      for the quarter. It is possible that our most significant customers in the
      future could be different from our largest customers today for a number of
      reasons, including customers’ deployment schedules and budget considerations. As
      a result, we believe we may experience significant fluctuations in our results
      of operations on a quarterly and annual basis.





Limited
      numbers of network and storage equipment vendors account for a majority of
      packet processor purchases in their respective markets. In particular, the
      market for network equipment that would include packet processors, such as
      routers, remote access concentrators and firewalls, is dominated by a few large
      vendors, including Cisco, Nortel Networks, Inc. and 3Com Corporation. As a
      result, our future success will depend upon our ability to establish and
      maintain relationships with these companies. If these network equipment vendors
      do not incorporate our packet processors into their products, our business,
      financial condition and results of operations could suffer.




**Our
      Operating Results May Fluctuate Significantly.**





Our
      operating results have fluctuated significantly in the past and we expect that
      they will continue to fluctuate in the future. This fluctuation is a result
      of a
      variety of factors including the following:




·
            General
                business conditions in our markets as well as global economic
                uncertainty;





·
            Increases
                or reductions in demand for our customers’ products;





·
            The
                timing and volume of orders we receive from our customers;





·
            Cancellations
                or delays of customer product orders;




·
              Acquisitions
                  or mergers involving us, our competitors or
                  customers;





·
            Any
                new product introductions by us or our competitors;





·
            Our
                suppliers increasing costs or changing the delivery of products to
                us;


-27-
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·
            Increased
                competition or reductions in the prices that we are able to
                charge;





·
            The
                variety of the products that we sell as well as seasonal demand for
                our
                products; and





·
            The
                availability of manufacturing capacity necessary to make our
                products.




**The
      Length Of Time It Takes To Develop Our Products And Make A Sale To Our Customers
      May Impair Our Operating Results.**





Our
      customers typically take a long time to evaluate our products. It usually takes
      our customers 3 to 6 months or more to test our products with an additional
      9 to
      18 months or more before they commence significant production of equipment
      incorporating our products. As a result of this lengthy sales cycle, we may
      experience a delay between increasing expenses for research and development
      and
      sales and marketing efforts on the one hand, and the generation of related
      revenues, if any, on the other hand. In addition, the delays inherent in such
      a
      lengthy sales cycle raise additional risks of customer decisions to cancel
      or
      change product plans, which could result in the loss of anticipated sales.
      Our
      business, financial condition and results of operations could suffer if
      customers reduce or delay orders or choose not to release products using our
      technology.





**We
      Depend Upon Independent Manufacturers And Limited Sources Of Supply.**





We
      rely
      on subcontractors to manufacture, assemble and test our packet processors.
      We
      currently subcontract our semiconductor manufacturing to Atmel Corporation,
      Toshiba Corporation, Philips Semiconductor and IBM. Since we depend upon
      independent manufacturers, we do not directly control product delivery schedules
      or product quality. None of our products are manufactured by more than one
      supplier. Since the semiconductor industry is highly cyclical, foundry capacity
      has been very limited at times in the past and may become limited in the
      future.





We
      depend
      on our suppliers to deliver sufficient quantities of finished products to us
      in
      a timely manner. Since we place orders on a purchase order basis and do not
      have
      long-term volume purchase agreements with any of our suppliers, our suppliers
      may allocate production capacity to their other customers’ products while
      reducing deliveries to us on short notice. In the past, one of our suppliers
      delayed the delivery of one of our products. As a result, we switched production
      of the product to a new manufacturer, which caused a 3-month delay in shipments
      to our customers. We have also experienced yield and test anomalies on a
      different product manufactured by another subcontractor that could have
      interrupted our customer shipments. In this case, the manufacturer was able
      to
      correct the problem in a timely manner and customer shipments were not affected.
      The delay and expense associated with qualifying a new supplier or foundry
      and
      commencing volume production can result in lost revenue, reduced operating
      margins and possible harm to customer relationships. The steps required for
      a
      new manufacturer to begin production of a semiconductor product
      include:





·
            Adapting
                our product design, if necessary, to the new manufacturer’s
                process;





·
            Creating
                a new mask set to manufacture the
                product;





·
            Having
                the new manufacturer prepare sample products so we can verify the
                product
                specification; and





·
            Providing
                sample products to customers for qualification.





In
      general, it takes from 3 to 6 months for a new manufacturer to begin full-scale
      production of one of our products. We could have similar or more protracted
      problems in the future with existing or new suppliers.





Toshiba
      Corporation manufactures products for us in plants located in Asia. To date,
      the
      financial and stock market dislocations that have occurred in the Asian
      financial markets in the past have not harmed our business. However, present
      or
      future dislocations or other international business risks, such as currency
      exchange fluctuations or recessions, could force us to seek new suppliers.
      We
      must place orders approximately 20 to 23 weeks in advance of expected delivery.
      This limits our ability to react to fluctuations in demand for our products,
      and
      could cause us to


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have
      an
      excess or a shortage of inventory of a particular product. In addition, if
      global semiconductor manufacturing capacity fails to increase in line with
      demand, foundries could allocate available capacity to larger customers or
      customers with long-term supply contracts. If we cannot obtain adequate foundry
      capacity at acceptable prices, or our supply is interrupted or delayed, our
      product revenues could decrease and our cost of revenues could increase. This
      could harm our business, financial condition and results of
      operations.





We
      regularly consider using smaller semiconductor dimensions for each of our
      products in order to reduce costs. We have begun to decrease the dimensions
      in
      our new product designs, and believe that we must do so to remain competitive.
      We may have difficulty decreasing the dimensions of our products. In the future,
      we may change our supply arrangements to assume more product manufacturing
      responsibilities. We may subcontract for wafer manufacturing, assembly and
      test
      rather than purchase finished products. However, there are additional risks
      associated with manufacturing, including variances in production yields, the
      ability to obtain adequate test and assembly capacity at reasonable cost and
      other general risks associated with the manufacture of semiconductors. We may
      also enter into volume purchase agreements that would require us to commit
      to
      minimum levels of purchases and which may require up-front investments. If
      we
      fail to effectively assume greater manufacturing responsibilities or manage
      volume purchase arrangements, our business, financial condition and results
      of
      operations will suffer.





**We
      Face Risks Associated With Acquisitions.**





We
      continually evaluate strategic acquisitions of businesses and technologies
      that
      would complement our product offerings or enhance our market coverage or
      technological capabilities and may make additional acquisitions in the future.
      Future acquisitions could be effected without shareholder approval, and could
      cause us to dilute shareholder equity, incur debt and contingent liabilities
      and
      amortize acquisition expenses related to intangible assets, any of which could
      harm our operating results and/or the price of our Common Stock. Acquisitions
      entail numerous risks, including:





·
            Difficulties
                in assimilating acquired operations, technologies and
                products;





·
            Diversion
                of management’s attention from other business concerns;





·
            Risks
                of entering markets in which we have little or no prior experience;
                and





·
            Loss
                of key employees of acquired organizations.





We
      may
      not be able to successfully integrate businesses, products, technologies or
      personnel that we acquire. If we fail to do so, our business, financial
      condition and results of operations could suffer.





**We
      Face Risks Associated With The Integration Of The IBM Network Processor Product
      Line Into Our Business.**





On
      December 31, 2003, we acquired certain assets and intellectual property related
      to the IBM network processor product line. Prior to our acquisition of these
      assets, we understand IBM informed its customers that it was discontinuing
      selected research and development activities in connection with the assets
      and
      would not be developing any related follow-on products with respect to the
      products associated with the acquired assets. While the Company has, to date,
      been able to retain the customers in existence for the network processors as
      of
      the time of the acquisition, there can be no assurance that the established
      customer base will continue to purchase the products based on the acquired
      assets from us or maintain their relationship with us in the future for
      follow-on products. If we fail to maintain the established customer base, we
      may
      not be able to maintain the revenue and profit performance levels that IBM
      established with respect to these products. Loss of the established customer
      base could negatively impact our results of operations, business and financial
      condition.


-29-
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**We
        Face Order And Shipment Uncertainties, Which Makes it Difficult to Forecast
        Future Revenues Accurately and May Cause Us to Hold Too Much Inventory.**


We
        generally make our sales under individual purchase orders that may be cancelled
        or deferred by customers short
        notice without significant penalty, if any. Cancellation or deferral of product
        orders could cause us to hold excess inventory, which, by increasing our
        costs
        without a commensurate increase in revenue, could harm our profit margins
        and
        restrict our ability to fund our operations. Such variability in customer
        demand
        coupled with customers’ ability to cancel orders on short notice, also makes it
        more difficult to forecast future revenue. We recognize revenue upon shipment
        of
        products to our customers. Revenue from products sold to distributors is
        deferred until the distributor sells the products to a third party. An
        unanticipated level of returns could harm our business, financial condition
        and
        results of operations.





**We
      Face Risks Associated With Evolving Industry Standards And Rapid Technological
      Change.**





The
      markets in which we compete are characterized by rapidly changing technology,
      frequent product introductions and evolving industry standards. Our performance
      depends on a number of factors, including our ability to do the
      following:





·
            Properly
                identify emerging target markets and related technological
                trends;





·
            Develop
                and maintain competitive products;





·
            Develop
                end-to-end, ubiquitous systems
                solutions;





·
            Develop,
                or partner with providers of, security services
                processors;





·
            Develop
                both hardware and software security services
                solutions;





·
            Enhance
                our products by adding innovative features that differentiate our
                products
                from those of competitors;





·
            Bring
                products to market on a timely basis at competitive prices; and





·
            Respond
                effectively to new technological changes or new product announcements
                by
                others.





Our
      past
      success has been dependent in part upon our ability to develop products that
      have been selected for design into new products of leading equipment
      manufacturers. However, the development of our packet processors is complex
      and,
      from time to time, we have experienced delays in completing the development
      and
      introduction of new products. We may not be able to adhere to our new product
      design and introduction schedules and our products may not be accepted in the
      market at favorable prices, if at all.





In
      evaluating new product decisions, we must anticipate future demand for product
      features and performance characteristics, as well as available supporting
      technologies, manufacturing capacity, competitive product offerings and industry
      standards. We must also continue to make significant investments in research
      and
      development in order to continue to enhance the performance and functionality
      of
      our products to keep pace with competitive products and customer demands for
      improved performance, features and functionality. The technical innovations
      required for us to remain competitive are complicated and require a significant
      amount of time and money. During fiscal 2004, we acquired certain technology
      for
      embedded processors, pattern matching and network processors. We may experience
      substantial difficulty in introducing new products, such as new products
      containing the acquired technologies and we may be unable to offer enhancements
      to existing products on a timely or cost-effective basis, if at all. For
      instance, the performance of our encryption/compression and public key
      processors depends upon the integrity of our security technology. If any
      significant advances in overcoming cryptographic systems are made, then the
      security of our encryption/compression and public key processors will be reduced
      or eliminated unless we are able to develop further technical innovations that
      adequately enhance the security of these products. Our inability to develop
      and
      introduce new products or enhancements directed at new industry standards could
      harm our business, financial condition and results of operations.




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Our Markets Are Highly Competitive.




We
      compete in
      markets that are intensely competitive and are expected to become increasingly
      competitive as current competitors expand their product offerings and new
      competitors enter the market. The markets that we compete in are subject to
      frequent product introductions with improved price-performance characteristics,
      rapid technological change, and the continued emergence of new industry
      standards. Our products compete with offerings from companies such as SafeNet,
      Inc., Broadcom Corporation, Cavium Networks, Freescale Technologies, Inc.,
      Intel
      Corporation, Agere Systems, Applied Micro Circuits Corporation, AHA and Indra
      Networks. Hifn was a wholly-owned subsidiary of Stac, Inc. until Hifn’s spin-off
      from Stac in 1996 upon which Stac assigned two license agreements entered into
      with IBM in 1994 in which Stac granted IBM the right to use, but not sublicense,
      our patented compression technology in IBM hardware and software products.
      Stac
      also assigned to us its license agreement with Microsoft Corporation
      (“Microsoft”) in 1994 whereby Stac granted Microsoft the right to use, but not
      sublicense, our compression technology in their software products. We expect
      significant future competition from major domestic and international
      semiconductor suppliers. Several established electronics and semiconductor
      suppliers have recently entered, or expressed an interest to enter, the network
      equipment market. We also may face competition from suppliers of products based
      on new or emerging technologies. Furthermore, many of our existing and potential
      customers internally develop solutions which attempt to perform all or a portion
      of the functions performed by our products.





A
      key
      element of our packet processor architecture is our encryption technology.
      Until
      recently, in order to export our encryption-related products, the U.S.
      Department of Commerce required us to obtain a license. Foreign competitors
      that
      were not subject to similar requirements have an advantage over us in their
      ability to establish existing markets for their products and rapidly respond
      to
      the requests of customers in the global market. Although the export restriction
      has been liberalized, we may not be successful in entering or competing in
      the
      foreign encryption markets. See “Our Products Are Subject To Export
      Restrictions.”





Many
      of
      our current and prospective competitors offer broader product lines and have
      significantly greater financial, technical, manufacturing and marketing
      resources than us. As a result, they may be able to adapt more quickly to new
      or
      emerging technologies and changes in customer requirements or to devote greater
      resources to promote the sale of their products. In particular, companies such
      as Intel Corporation, Lucent Technologies Inc., Motorola, Inc., National
      Semiconductor Corporation and Texas Instruments Incorporated have a significant
      advantage over us given their relationships with many of our customers, their
      extensive marketing power and name recognition and their much greater financial
      resources. In addition, current and potential competitors may decide to
      consolidate, lower the prices of their products or bundle their products with
      other products. Any of the above would significantly and negatively impact
      our
      ability to compete and obtain or maintain market share. If we are unable to
      successfully compete against our competitors, our business, results of
      operations and financial condition will suffer.





We
      believe that the important competitive factors in our markets are the
      following:





·
            Performance;





·
            Price;





·
            The
                time that is required to develop a new product or enhancements to
                existing
                products;




·
            The
                ability to achieve product acceptance with major network and storage
                equipment vendors;





·
            The
                support that exists for new network and storage standards;





·
            Features
                and functionality;





·
            Adaptability
                of products to specific applications;





·
            Reliability;
                and





·
            Technical
                service and support as well as effective intellectual property
                protection.


-31-
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If
      we are
      unable to successfully develop and market products that compete with those
      of
      other suppliers, our business, financial condition and results of operations
      could be harmed. In addition, we must compete for the services of qualified
      distributors and sales representatives. To the extent that our competitors
      offer
      distributors or sales representatives more favorable terms, these distributors
      and sales representatives may decline to carry, or discontinue carrying, our
      products. Our business, financial condition and results of operations could
      be
      harmed by any failure to maintain and expand our distribution
      network.





**Our
      Success Depends Upon Protecting Our Intellectual Property.**





Our
      proprietary technology is critical to our future success. We rely in part on
      patent, trade, trademark, mask work and copyright law to protect our
      intellectual property. We own twenty-four (24) United States patents and ten
      (10) foreign patents. Our issued patents and patent applications primarily
      cover
      various aspects of our compression, flow classification, bandwidth management,
      cryptographic packet processing, rate shaping and pattern matching technologies
      and have expiration dates ranging from 2007 to 2022. Of our issued United States
      patents we have six (6) in renewal litigation which is expected to complete
      before the end of Fiscal Year 2007. We also have four (4) pending patent
      applications in the United States and a total of twelve (12) in Europe, Asia
      and
      Australia covering flow classification, cryptographic packet processing, and
      pattern matching. Patents may not be issued under our current or future patent
      applications, and the patents issued under such patent applications could be
      invalidated, circumvented or challenged. In addition, third parties could make
      infringement claims against us in the future. Such infringement claims could
      result in costly litigation. We may not prevail in any such litigation or be
      able to license any valid and infringed patents from third parties on
      commercially reasonable terms, if at all. Regardless of the outcome, an
      infringement claim would likely result in substantial cost and diversion of
      our
      resources. Any infringement claim or other litigation against us or by us could
      harm our business, financial condition and results of operations. The patents
      issued to us may not be adequate to protect our proprietary rights, to deter
      misappropriation or to prevent an unauthorized third party from copying our
      technology, designing around the patents we own or otherwise obtaining and
      using
      our products, designs or other information. In addition, others could develop
      technologies that are similar or superior to our technology.





We
      also
      claim copyright protection for certain proprietary software and documentation.
      We attempt to protect our trade secrets and other proprietary information
      through agreements with our customers, employees and consultants, and through
      other security measures. However, our efforts may not be successful.
      Furthermore, the laws of certain countries in which our products are or may
      be
      manufactured or sold may not protect our products and intellectual
      property.





**Network
      And Storage Equipment Prices Typically Decrease.**





Average
      selling prices in the networking, storage and semiconductor industries have
      rapidly declined due to many factors, including:





·
            Rapidly
                changing technologies;





·
            Price-performance
                enhancements; and





·
            Product
                obsolescence.




The
      decline in the average selling prices of our products may cause substantial
      fluctuations in our operating results. We anticipate that the average selling
      prices of our products will decrease in the future due to product introductions
      by our competitors, price pressures from significant customers and other
      factors. Therefore, we must continue to develop and introduce new products
      that
      incorporate features which we can sell at higher prices. If we fail to do so,
      our revenues and gross margins could decline, which would harm our business,
      financial condition and results of operations.


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We
      Face Product Return, Product Liability And
      Product Defect Risks.




Complex
      products such as ours frequently contain errors, defects and bugs when first
      introduced or as new versions are released. We have discovered such errors,
      defects and bugs in the past. Delivery of products with production defects
      or
      reliability, quality or compatibility problems could hinder market acceptance
      of
      our products. This could damage our reputation and harm our ability to attract
      and retain customers. Errors, defects or bugs could also cause interruptions,
      delays or a cessation of sales to our customers. We would have to expend
      significant capital and resources to remedy these problems. Errors, defects
      or
      bugs could be discovered in our new products after we begin commercial
      production of them, despite testing by us and our suppliers and customers.
      This
      could result in additional development costs, loss of, or delays in, market
      acceptance, diversion of technical and other resources from our other
      development efforts, claims by our customers or others against us or the loss
      of
      credibility with our current and prospective customers. Any such event would
      harm our business, financial condition and results of operations.





**We
      Depend Upon Key Personnel.**





Our
      success greatly depends on the continued contributions of our key management
      and
      other personnel, many of whom would be difficult to replace. We do not have
      employment contracts with any of our key personnel, nor do we maintain any
      key
      man life insurance on any of our personnel. We have recently entered into
      severance and change of control agreements with our executive and other
      officers; however, there can be no assurance that such personnel will
      necessarily remain with the Company. It may be difficult for us to integrate
      new
      members of our management team. We must also attract and retain experienced
      and
      highly skilled engineering, sales and marketing and managerial personnel.
      Competition for such personnel has, in the past, been intense in the geographic
      areas and market segments in which we compete, and we may not be successful
      in
      hiring and retaining such people. If we lose the services of any key personnel,
      or cannot attract or retain qualified personnel, particularly engineers, our
      business, financial condition and results of operations could suffer. In
      addition, companies in technology industries whose employees accept positions
      with competitors have in the past claimed that their competitors have engaged
      in
      unfair competition or hiring practices. We could receive such claims in the
      future as we seek to hire qualified personnel. These claims could result in
      material litigation. We could incur substantial costs in defending against
      any
      such claims, regardless of their merits.





We
      currently have an interim Chief Executive Officer. Since the departure of our
      prior Chairman, President and CEO, Christopher G. Kenber, on November 9, 2006,
      we have been engaged in a search for a new CEO. Though we hope to hire a
      qualified candidate in the near term, no assurance can be given that we will
      be
      able to attract and retain a suitable CEO. An extended period of time without
      a
      permanent CEO could materially adversely affect our business, financial
      conditions or results of operations.





**The
      Cyclical Nature Of The Semiconductor Industry May Harm Our Business.**





The
      semiconductor industry has experienced significant downturns and wide
      fluctuations in supply and demand. The industry has also experienced significant
      fluctuations in anticipation of changes in general economic conditions. This
      has
      caused significant variances in product demand, production capacity and rapid
      erosion of average selling prices. Industry-wide fluctuations in the future
      could harm our business, financial condition and results of
      operations.





**We
      Face Risks Associated With Our International Business Activities.**





A
      significant portion of our products are sold to customers outside the United
      States. If our international sales increase, particularly in light of decreased
      export restrictions, we may encounter increased risks inherent in international
      operations. All of our international sales to date are denominated in U.S.
      dollars. As a result, if the value of the U.S. dollar increases relative to
      foreign currencies, our products could become less competitive in international
      markets. We also obtain some of our manufacturing, assembly and test services
      from suppliers located outside the United States. International business
      activities could be limited or disrupted by any of the following:




·
            The
                imposition of governmental
                controls;


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·
            Export
                license/technical review requirements; 
 ·
            Restrictions
                on the export of technology; 
 ·
            Currency
                exchange fluctuations; 
 ·
            Political
                instability; 
 ·
            Financial
                and stock market dislocations; 
 ·
            Military
                and related activities; 
 ·
            Trade
                restrictions; and 
 ·
            Changes
                in tariffs.




Demand
      for our products also could be harmed by seasonality of international sales
      and
      economic conditions in our primary overseas markets. These international factors
      could harm future sales of our products to international customers and could
      harm our business, financial condition and results of operations in
      general.





The
      Company has established a development facility in China. The facility faces
      some
      of the same risks with respect to international business activities as
      referenced above, including, without limitation, the imposition of governmental
      controls, currency exchange fluctuations and political instability.





As
      of
      September 30, 2006, the aggregate amount of loans to the shareholders of Ansai
      was RMB 2.0 million (USD $250,000). Depending on future operational needs and
      profitability, Ansai may require additional loans in the future.





**Our
      Products Are Subject To Export Restrictions.**





The
      encryption algorithms embedded in our products are a key element of our packet
      processor architecture. These products are subject to U.S. Department of
      Commerce export control restrictions. Our network equipment customers may only
      export products incorporating encryption technology if they obtain a one-time
      technical review. These U.S. export laws also prohibit the export of encryption
      products to a number of countries deemed by the U.S. to be hostile. Many foreign
      countries also restrict exports to many of these countries deemed to be
“terrorist-supporting” states by the U.S. government. Because the restrictions
      on exports of encryption products have been liberalized, we, along with our
      network equipment customers, have an opportunity to effectively compete with
      our
      foreign competitors. The existence of these restrictions until recently may
      have
      enabled foreign competitors facing less stringent controls on their products
      to
      become more established and, therefore, more competitive in the global market
      than our network equipment customers. In addition, the list of products and
      countries for which export approval is required, and the regulatory policies
      with respect thereto, could be revised, and laws limiting the domestic use
      of
      encryption could be enacted. While the U.S. government now allows U.S. companies
      to assume that exports to non-government end-users will be approved within
      30
      days of official registration with the Department of Commerce, the sale of
      our
      packet processors could be harmed by the failure of our network equipment
      customers to obtain the required approvals or by the costs of
      compliance.




**Our
      Stock Price May Be Volatile.**





The
      market price of our Common Stock has fluctuated in the past and is likely to
      fluctuate in the future. In addition, the securities markets have experienced
      significant price and volume fluctuations and the market prices of the
      securities of technology-related companies including networking, storage and
      semiconductor companies have been especially volatile. Such fluctuations can
      result from:





·
            Quarterly
                variations in operating results;


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·
            Announcements
                of new products by us or our competitors;




·
            The
                gain or loss of significant customers;




·
            Changes
                in analysts’ estimates;





·
            Short-selling
                of our Common Stock; and





·
            Events
                affecting other companies that investors deem to be comparable to
                us.




**If
      We Determine That Our Long-Lived Assets Have Been Impaired Or That Our Goodwill
      Has Been Further Impaired, Our Financial Condition and Results of Operations
      May
      Suffer.**





We
      perform impairment analyses of goodwill and long-lived and intangible assets
      on
      an annual basis. During fiscal 2003 and 2002, we determined that impairment
      had
      been realized on certain developed technology and goodwill, resulting in
      recognition of impairment charges of $3.9 million and $27.4 million,
      respectively. Pursuant to SFAS 142, “Goodwill and Other Intangible Assets,” we
      will continue to perform an annual impairment test and if, as a result of this
      analysis, we determine that there has been an impairment of our goodwill or
      other long-lived and intangible assets, asset impairment charges will be
      recognized. Approximately $1.0 million of goodwill remains as of December 31,
      2006. If we determine that our long-lived assets have been impaired or that
      our
      goodwill has been further impaired, our financial condition and results of
      operations may suffer.





**Item
      6.**  **Exhibits**




**Exhibit**
                **Number**
              ****
              **Exhibit**31.1
              
              Certification
                  of Chief Executive Officer pursuant to Section 302(a) of the
                  Sarbanes-Oxley Act of 2002.31.2
              
              Certification
                  of Chief Financial Officer pursuant to Section 302(a) of the
                  Sarbanes-Oxley Act of 2002.32.1
              
              Certification
                  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
                  as
                  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.32.2
              
              Certification
                  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
                  as
                  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.


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**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the Registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.






hi/fn,
                inc.
              (Registrant)Date: February
              9, 2007
            
            By:
              /s/ William R. WalkerVice
              President, Finance, Chief Financial Officer and Secretary (principal
              financial and accounting officer)


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**INDEX
      TO EXHIBITS**




**Exhibit**
              **Number**
            ****
            **Exhibit**31.1
            
            Certification
                of Chief Executive Officer pursuant to Section 302(a) of the
                Sarbanes-Oxley Act of 2002.31.2
            
            Certification
                of Chief Financial Officer pursuant to Section 302(a) of the
                Sarbanes-Oxley Act of 2002.32.1
            
            Certification
                of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.32.2
            
            Certification
                of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.





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